The Corner

Tragedy, Statistics, and Markets

Thank you, Jonah, for your thoughts here. The Gulf has already been through so much in the past half-decade. 

I wonder at fresh assertions, such as the Union Leader’s, that offshore drilling is “statistically extremely safe.” It may be that the risk — or more appropriately, the uncertainty — of such technologically challenging deep-water exploration and production projects is statistically unknowable. We lack thick historical data. The data that we do have could be imperfectly applicable to future projects, as each drill challenge poses its own unique uncertainties. At minimum: Until we know the cause of the explosion, the reasons why several levels of fail-safes did not work, and whether and how such information will help oil companies and regulators assess risk and uncertainty at other drill sites, it may be a leap to make such assertions.

It may be that statistics are an imperfect measure here, anyway. The risk, if we could figure it out (which we can’t), may be low. But the effects of that risk materializing may be so catastrophic that the risk level is not a good measure of, well, the risk. Put another way: It’s like saying that both the risk of a nuclear attack in Times Square and the risk of a three-car pileup there are roughly 1 percent. The risk may be the same, but, obviously, one has such a disproportionate impact on our world that we should think about it a little differently. 

The emerging realization among investors that these mile-plus-deep, space-shuttle-level deep-water projects do pose unknowable yet catastrophic uncertainties could change their financing prospects — and ultimately could change the price of oil, too. 

It can cost $1 billion to design, engineer, build, and deploy a Deepwater Horizon. In the past, oil companies have financed these things as “non-recourse,” or at least “limited recourse.” That means that the oil company doesn’t own the offshore drill platform and doesn’t owe money for the platform on its own balance sheet.

But it is becoming very clear, now, that the oil company does own the ultimate catastrophic risk here, at least until the point of bankruptcy. BP must pay the cost — the financial cost, at least — of the cleanup. That unfolding reality changes investors’ perception of the risk of buying a big oil company’s shares, or even lending to such a company. The disaster is especially relevant to investment decisions when the big oil company’s main claim to fame is its technological and engineering prowess, now that a lot of the easy oil is gone or remains stuck in politically inhospitable places. BP has big assets — but it also has unknowable liabilities now, present and future. 

As for the drilling platform itself: Someone has to own the platform, but who that someone is doesn’t really matter. Companies that aren’t oil majors go bankrupt all the time. What matters is who finances the platform. That’s usually a big bank syndicate or bondholders. Although their investment is limited, it’s now obvious that it can vanish in an instant.

So — insurance becomes even more important. But who will insure — or reinsure — the unknowable? Maybe some group of insurers and reinsurers — but they may do it more expensively, a lot more expensively. Or maybe no one. It’s impossible to insure nuclear power; in the United States, the government does it.

If it turns out that no one will insure or finance a deep-water platform, or that no one will do it as inexpensively as insurers have in the past, the government should not interfere with this market signal. 

The U.S. government, for example, should not offer any kind of last-resort insurance or financing. If deep-water projects become even more expensive or economically impossible, that’s a market sign that the price of oil needs to be higher, possibly much higher. It’s hard enough to price in all of the costs of oil already, without the government adding yet more interference. 

That all sounds very neat, but it will not end there. Private-sector financial companies may not take on an unknowable risk, at least not for a high return. But a “too big to fail” financial company may invest in exactly what the government wishes it to. That’s why we need free markets in finance. What hope does a Gulf fisherman have against government allocation of credit?

But even if we figure that problem out, it won’t end there, either. The Chinese government, for example, could backstop economically unfeasible offshore projects, even if markets won’t. 

To end on a mildly optimistic note: One can grasp hope from the idea that dedicated and intelligent minds are working on this unfolding cataclysm as we speak. America has achieved great engineering feats before, and plugging this oil gusher quickly soon would rank high among them.

Nicole Gelinas is a contributing editor to the Manhattan Institute’s City Journal and author of After the Fall. 

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